Five Key Business Valuation Considerations

What are the main elements that underpin a business valuation
June 19, 2020

1. Cash is King. At root, almost every business valuation isbased on an estimate of the amount of cash that an investor in this companywould be able to enjoy in the future. Essentially this is the same in respectof every investment-if you invest in a bond or in real estate, the value ofsuch an investment relates to the interest rate on the bond or the rentspayable from the building and the payment at the end of the investment, i.e.the repayment of the bond or the sale of the real estate (as the case may be).The same is the applicable in the case of an investment in a closely heldcompany.

2. How risky is the company? The risk reflects an assessmentof how likely an investor will be able to enjoy the future estimated futurecash flows of the company. The lower the risk, the higher the value and viceversa. All other things being equal, an investor would pay more for awell-established, stable company with estimated cash flows of $500,000 than theinvestor would pay for an estimated cash flow of $500,000 from a startupcompany with no proven business model.

3. The Valuation Date. Every valuation requires theestablishment of a valuation date. This draws a line in the sand stating thatonly information that is known or reasonably foreseeable as of that date is tobe taken into account in the valuation exercise. In many cases, a valuation iscarried out after the valuation date but events occurring after that date arenot taken into account in the establishment of the value.

4. How Low Can You Go? In some cases the most appropriate wayto value a business is to subtract what it owes from what it owns resulting inan asset value for the company. Essentially this approach assumes that thecompany ceases business, sells off its assets and pays its debts with the netamount representing its value. It’s appropriate to use this method when thevalue derived from the cash flow methodologies produce a value lower than itsnet assets - in other words, this is often the minimum value for a business.

5. Minority Report. In many cases the valuation relates toless than 50% of a company. An investor purchasing such an interest would notpay a pro rata percentage of the total value of the company. In addition to thegeneral risks of an investment in the company, the investor would be taking onthe risk that the controlling shareholder would abuse their position to thedetriment of the minority shareholders and the additional risk that it would bedifficult to resell the interest since the market for such an interest is verylimited. As a result it is common to see discounts for lack of control and lackof marketability applied to non-controlling interests which, when combined insome cases can reach as high as 50% of the pro rata value.